Solution manual cost accounting 8th by kinney chapter 02

Terminology Actual cost system: A costing system that charges Work in Process Inventory with the actual direct material, direct labor, and overhead costs of producing a product Appraisa

Learning Objectives

After reading and studying Chapter 2, you should be able to answer the following questions:

1 Why are costs associated with a cost object?

2 What assumptions do accountants make about cost behavior, and why are these assumptions necessary?

3 How are costs classified on the financial statements, and why are such classifications useful?

4 How does the conversion process occur in manufacturing and service companies?

5 What are the product cost categories, and what items comprise those categories?

6 How and why does overhead need to be allocated to products?

7 How is cost of goods manufactured calculated and used in preparing an income statement?

COST TERMINOLOGY AND COST

BEHAVIORS

CHAPTER

2

Terminology Actual cost system: A costing system that charges Work in Process Inventory with the actual direct

material, direct labor, and overhead costs of producing a product

Appraisal costs: Costs incurred to find mistakes not eliminated through prevention

Conversion costs: The costs (direct labor and overhead) required to convert direct material into a

finished good or service

Cost: The monetary measure of resources given up to attain an objective such as producing a product or

providing a service

Cost allocation: The assignment of an indirect cost to one or more cost objects using some reasonable

allocation base or driver

Cost driver: A factor that has an absolute cause-effect relationship to a cost

Cost management system (CMS): A set of formal methods developed for planning and controlling an

organization’s cost-generating activities relative to its strategy, goals, and objectives

Cost object: Anything for which management wants to collect or accumulate costs

Cost of goods manufactured (CGM): The total cost of the goods completed and transferred to Finished

Goods Inventory during the period

Direct costs: Costs which are conveniently and economically traceable to a particular cost object

Direct labor: Labor costs of individuals who work specifically on manufacturing a product or performing a

service

Direct material: Material costs that can be easily and economically traced to a product

Distribution cost: Any cost incurred to warehouse, transport, or deliver a product or service

Expired cost: The portion of an asset’s value that has been consumed or sacrificed during the period

and which is reported as an expense or loss on the income statement

Failure costs: Internal costs (e.g., scrap and rework) and external costs (e.g., product returns, warranty

costs, complaints to customer service) caused by quality problems

Finished goods: The costs of units of inventory that have been fully completed

Fixed cost: A cost that remains constant in total within the relevant range of activity but varies on a unit

basis

Indirect costs: Costs that cannot be economically traced to a particular cost object and therefore must

be allocated to the object instead

Inventoriable costs: The direct costs of materials and labor plus the indirect costs of overhead which

become part of the cost of inventory

Manufacturer: A company engaged in a high degree of conversion of raw material that results in a

tangible output

Mixed cost: A cost that has both a variable and a fixed component and that changes with changes in

activity, but not proportionately

Normal cost system: A costing system that charges the Work in Process Inventory with the actual costs

of direct material and direct labor and an assigned amount of overhead based on a predetermined overhead rate

Overhead: Any factory or production cost that is indirect to the product or service (that is, a

production-related cost that cannot be directly traced to the product)

Period costs: Costs related to business functions other than production (such as selling and

administrative costs) which are expensed in the current accounting period

Predetermined overhead rate: A charge per unit of activity used to allocate or apply overhead cost from

the Overhead Control account to Work in Process Inventory for the period’s production or services

Predictor: An activity measure that, when changed, is accompanied by consistent, observable changes

in a cost item

Prevention costs: Costs incurred to improve quality by precluding product defects and improper

processing from occurring

Prime costs: The primary costs (direct material and direct labor) of producing a product or delivering a

service

Product costs: Costs associated with making or acquiring the products or providing the services that

directly generate the revenues of an entity

Raw material: The materials used in the production process From the standpoint of conversion, raw

material represents work not yet started

Relevant range: The assumed range of activity that reflects the company’s normal operating range and

over which unit variable costs and total fixed costs are assumed to remain constant

Service company: A firm engaged in a high or moderate degree of conversion using a significant

amount of labor

Step cost: A cost that increases (decreases) in distinct amounts because of increased (decreased)

activity Step variable costs have small steps and step fixed costs have large steps

Total cost to account for: The sum of the beginning WIP Inventory and the total current manufacturing

costs (DM, DL, OH)

Unexpired cost: The portion of an asset’s value that has not yet been consumed or sacrificed and which

is reported on the balance sheet as an asset

Variable cost: A cost that varies in total proportionately with changes in activity but which is a constant

amount per unit

Work in process: The costs of work started but not yet completed

Lecture Outline LO.1 Why are costs associated with a cost object?

A Introduction

1 This chapter provides the necessary terminology to understand and communicate cost and management accounting information The chapter also presents cost flows and the process of cost accumulation in a production environment

2 To effectively communicate information, accountants must clearly understand the differences among the various types of costs, their computations, and their usage

3 To be useful, the term cost must be defined more specifically before “the cost” of a product or

service can be determined and communicated to others

a Cost reflects the monetary measure of resources given up to attain an objective such as

making a good or delivering a service

b Unexpired cost: The portion of an asset’s value that has not yet been consumed or

sacrificed and which is reported on the balance sheet as an asset

c Expired cost: The portion of an asset’s value that has been consumed or sacrificed during

the period and which is reported as an expense on the income statement

B Cost Terminology

1 A cost management system is a set of formal methods developed for planning and controlling

an organization’s cost-generating activities relative to its strategy, goals, and objectives

2 Some important types of costs are summarized in text Exhibit 2–1 (p 25)

3 Association with Cost Object

a A cost object is anything (e.g., a product, a product line, a customer) for which management

wants to collect or accumulate costs

b The costs associated with any cost object can be classified according to their relationship to the cost object

c Direct costs are costs that can be conveniently and economically traced to the cost object

i For example, the cost of steel used by Toyota to manufacture a Tundra pickup truck is a direct cost when the cost object is the Tundra product

d Indirect costs are costs that cannot be economically traced to the cost object but instead

must be allocated to the cost object

i For example, the cost of glue used to manufacture a Tundra pickup truck is an indirect cost when the cost object is the Tundra pickup truck

e Costs may be direct or indirect depending upon the cost object

i As above, the glue used used to manufacture a Tundra pickup truck is an indirect cost when the cost object is the Tundra pickup truck but is a direct cost when the cost object is the Princeton plant in which the Tundra is manufactured

LO.2 What assumptions do accountants make about cost behavior, and why are these

assumptions necessary?

C Reaction to Changes in Activity

1 General

a A cost’s behavior pattern is described according to the way its total cost (rather than its unit cost) reacts to changes in a related activity measure over the relevant range

b Common activity measures include production volume, service and sales volumes, hours of machine time used, pounds of material moved, and number of purchase orders processed

c The relevant range is the assumed range of activity that reflects the company’s normal

operating range

d Accountants assume that there are three cost behavior patterns: variable, fixed, and mixed

i A variable cost is a cost that varies in total in direct proportion to changes in activity but

is constant on a unit basis Although accountants view variable costs as linear,

economists view these costs as curvilinear as shown in text Exhibit 2–2 (p 27)

ii A fixed cost is a cost that remains constant in total within the relevant range of activity

but varies inversely with changes in the level of activity on a per unit basis The variable

and fixed cost behavior patterns are summarized in text Exhibit 2–3 (p 28)

iii A mixed cost has both a variable and a fixed component as illustrated in text Exhibit 2-4 (p 28) Mixed costs must be separated into their variable and fixed components in order

to make valid estimates of total costs at various activity levels

e Management may decide to “trade” fixed and variable costs for one another

i For example, installing new automated production equipment would result in an additional large fixed cost for depreciation but would eliminate the variable cost of wages for hourly production workers

ii A shift from one type of cost behavior to another type changes a company’s basic cost structure and can have a significant impact on its profits

f A step cost is a cost that shifts upward or downward when activity changes by a certain

interval or “step.” Step costs can be variable or fixed; step variable costs have small steps while step fixed costs have large steps

g Assuming a variable cost is constant per unit and a fixed cost is constant in total within the relevant range can be justified for two reasons:

i If the company operates only within the relevant range of activity, the assumed conditions approximate reality and, thus, the cost behaviors are appropriate

ii Second, selection of a constant per-unit variable cost and a constant total fixed cost provides a convenient, stable measurement for use in planning, controlling, and decision making activities

h Selection of an appropriate activity measure is important

i A predictor is an activity measure that, when changed, is accompanied by consistent,

observable changes in a cost item However, simply because two items change together does not prove that the predictor causes the change

ii A cost driver is a predictor that has an absolute cause-and-effect relationship with the

cost in question

iii Text Exhibit 2–5 (p 30) illustrates the linear cause-and-effect relationship between

production volume and total raw material cost

iv Traditionally, a single predictor has often been used to predict costs but accountants and managers are realizing that single predictors do not necessarily provide the most reliable forecasts, thus causing a movement toward activity-based costing, which uses multiple cost drivers to predict different costs

LO.3 How are costs classified on the financial statements, and why are such classifications useful?

2 Classification on the Financial Statements

a The balance sheet is a statement of unexpired costs (assets) and liabilities and owners’ capital whereas the income statement is a statement of revenues and expired costs (expenses and losses)

b The matching concept provides a basis for deciding when an unexpired cost becomes an expired cost and is moved from an asset category to an expense or loss category

c When the product is specified as the cost object, all costs can be classified as either product

or period costs

d Product costs, also called inventoriable costs, are related to making or acquiring the

products or providing the services that directly generate the revenues of an entity

i Direct material is any material that can be easily and economically traced to a product

ii Direct labor refers to the time spent by individuals who work specifically on manufacturing

a product or performing a service

iii Overhead is any factory or production cost that is indirect (i.e., not direct material or direct labor) to the product or service

e The sum of direct labor and overhead costs is referred to as conversion cost as those are

the costs incurred to convert materials into products

f The sum of direct material and direct labor cost is referred to as prime cost as those are the

primary costs in making most products

g Period costs are related to business functions other than production, such as selling and

administration

i Period costs are generally more closely associated with a particular time period than with making or acquiring a product or performing a service

ii Period costs that have future benefit are classified as assets, whereas those having no future benefit are expenses For example, prepaid insurance (asset) becomes insurance expense

iii Distribution costs are period costs incurred to warehouse, transport, or deliver a

product or service

LO.4 How does the conversion process occur in manufacturing and service companies?

D The Conversion Process

1 General

a In general, product costs are incurred in the production (or conversion) area and period costs are incurred in all nonproduction (or nonconversion) areas

b Conversion process outputs are usually either products or services

c See text Exhibit 2–6 (p 31) for a comparison of the conversion activities of different types of

organizations

d Firms that engage in only low or moderate degrees of conversion (such as retailers) can conveniently expense insignificant costs of labor and overhead related to conversion

e In high-conversion firms, the informational benefits gained from accumulating the material, labor, and overhead costs incurred to produce outputs significantly exceed clerical

accumulation costs as illustrated in text Exhibit 2-7 (p 32)

f A manufacturer is defined as any company engaged in a high degree of conversion of raw

material input into a tangible output using people and machines

g A service company refers to a for-profit business or not-for-profit organization that uses a

significant amount of labor to engage in a high or moderate degree of conversion, whose outputs can be tangible (e.g., an architectural drawing) or intangible (e.g., insurance

protection)

2 Retailers versus Manufacturers/Service Companies

a Retail companies purchase goods in finished or almost finished condition so those goods typically need little, if any, conversion before being sold to customers

b In comparison, manufacturers and service companies engage in activities that involve the physical transformation of inputs into, respectively, finished products and services

c A cost accounting system is required to assign the materials or supplies and conversion costs

of manufacturers and service companies to output to determine the cost of inventory

produced and cost of goods sold or services rendered

d The production or conversion process occurs in three stages:

i Work not started (raw material);

ii Work started but not completed (work in process); and

iii Work completed (finished goods)

e Text Exhibit 2–8 (p 33) compares the input–output relationships of a retail company with

those of a manufacturing/service company

i As shown in the exhibit, unlike manufacturers and service firms, retail firms have no

“production center” where input factors such as raw material enter and are transformed and stored until the goods or services are completed

f Text Exhibit 2–9 (p 35) depicts some of the costs associated with each stage of the

conversion process

i In the first stage of processing, the costs incurred reflect the prices paid for raw materials and/or supplies

ii As work progresses through the second stage, accrual-based accounting requires that labor and overhead costs related to the conversion of raw materials or supplies be accumulated and attached to the goods

iii The total costs incurred in stages 1 and 2 equal the total production cost of finished goods in stage 3

3 Manufacturers versus Service Companies

a In a service firm, the work not started stage of processing normally consists of the cost of supplies needed to perform the services (Supplies Inventory)

i When supplies are placed into process, labor and overhead are added to achieve

finished results Thus, some service firms use two accounts (a Supplies Inventory account and a Work in Process Inventory account) to accumulate these costs

b Manufacturers use three inventory accounts: (1) Raw Material Inventory (instead of

Supplies), (2) Work in Process Inventory (for partially converted goods), and (3) Finished Goods Inventory

c Because services generally cannot be warehoused, costs of finished jobs are usually

transferred immediately to the income statement to be matched against service revenue rather than being carried on the balance sheet in a finished goods inventory account

d All organizations (retailers, manufacturers, and service firms) need management and cost accounting techniques to help them find ways to reduce costs without sacrificing quality or productivity

LO.5 What are the product cost categories, and what items comprise those categories?

E Components of Product Cost

1 Direct Material

a Direct material cost includes the cost of all materials used to manufacture a product or

perform a service

b Material costs that are not conveniently or economically traceable are classified as indirect costs and included in overhead

c See text Exhibit 2–9 (p 35) for an example of direct vs indirect material costs

2 Direct labor

a Direct labor refers to the effort of individuals who manufacture a product or perform a service

b Direct labor cost consists of the wages or salaries paid to direct labor personnel conveniently traceable to the product or service

i Direct labor should include basic compensation, production efficiency bonuses, the employees’ share of Social Security and Medicare taxes, and if the company’s operations are relatively stable, all employer-paid insurance costs, holiday and vacation pay, and pension and other retirement benefits

c Labor costs that cannot be reasonably or economically traced are classified as indirect costs and included in overhead

i Although fringe benefit costs should be treated as direct labor, the time, effort, and clerical expense of tracing such costs to production do not warrant such treatment

ii Costs for overtime or shift premiums are usually considered overhead rather than direct labor cost and are allocated among all units unless the overtime costs resulted from expediting a customer’s request

d Because laborers historically performed the majority of conversion activity, direct labor once represented a large portion of total manufacturing cost

i Now, in highly automated work environments, direct labor often represents only 10 to 15 percent of total manufacturing cost

3 Overhead

a Overhead is any factory or production cost that is indirect to manufacturing a product or providing a service

b Overhead includes indirect material, indirect labor and other production-related costs such as factory depreciation, factory utilities, factory insurance, etc

c Automated and computerized technologies have made manufacturing more capital intensive and overhead has become a progressively larger proportion, and such costs merit much more attention than they did in the past

d Variable overhead includes the costs of indirect material, indirect labor paid on an hourly basis, lubricants used for machine maintenance, and the variable portion of factory utility charges

e Fixed overhead includes costs such as straight-line depreciation on factory assets, factory license fees, factory insurance and property taxes, and fixed indirect labor costs such as salaries for production supervisors, shift superintendents, and plant managers

f Quality costs are an important component of overhead cost since high-quality products or services enhance a company’s ability to generate revenues and produce profits Managers are concerned about production process quality because higher process quality leads to shorter production time and reduced costs for spoilage and rework

i Prevention costs are incurred to improve quality by precluding product defects and

improper processing from occurring

ii Appraisal costs are costs incurred for monitoring or inspecting products in order to find

mistakes not eliminated through prevention

iii Internal Failure costs are costs such as scrap and rework that result when quality

problems are detected before the product reaches the final customer

iv External Failure costs are incurred when quality problems are not discovered until after

the product has been delivered to the final customer and include costs such as product returns and warranty claims

g Some quality costs are variable in relation to the quantity of defective output, some are step fixed with increases at specific levels of defective output, and some are fixed for a specific time

LO.6 How and why does overhead need to be allocated to products?

F Accumulation and Allocation of Overhead

1 General

a To satisfy the historical cost and matching principles, which require that all production or acquisition costs attach to the units produced or purchased, overhead must be

accumulated over a period and allocated to the products manufactured or services rendered during that period

b Cost allocation refers to the assignment of an indirect cost to one or more cost objects

using some reasonable allocation base or driver